The big ol’ world of investing can feel overwhelming to navigate. There are stocks, bonds, commodities, mutual funds, and exchange-traded funds, to name a few.
With so many choices, it can be hard to nail down just where to start.
The confusion is especially real for investors who are just getting into the game, whether it’s because they are young, earning more for the first time, or are finally ready to invest after paying down student loans.
One investment type that has gained in popularity with all types of investors, both new and seasoned, is the exchange-traded fund. This investment type is more commonly referred to by its acronym, “ETF.”
How do ETFs work? An ETF is an investment fund that you can buy and sell like a stock, but that potentially bundles together some other investment types, such as bonds.
In this way, they are similar to mutual funds, though ETFs are structured to give them some tactical advantages over mutual funds.
To understand the benefits of the ETF, it helps to first know what an ETF is and how ETFs work. With some ETF basics down, you can decide whether it’s the right choice for your investment portfolio.
What is an ETF?
An ETF is an investment fund that pools together different assets, such as stocks, bonds, commodities, or currencies, and then divides its ownership up into shares.
This means that with just a few clicks, it is possible to buy one fund that provides exposure to hundreds or thousands of investment securities. ETFs are often heralded for helping investors gain diversified exposure to the market for a relatively low cost.
This is important to understand—the ETF is simply the suitcase that packs investments together. When you invest in an ETF, you are exposed to the underlying investment. For example, if you are invested in a stock ETF, you are invested in stocks. If you are invested in a bond ETF, you are invested in bonds.
ETFs were created to try and improve upon the mutual fund. Unlike a mutual fund, which only trades once a day, an ETF is structured so that it trades like a stock, on an exchange (such as the New York Stock Exchange), during normal market hours.
While the market is open, it is possible to buy or sell an ETF nearly instantaneously—and see an ETF’s value in real-time. A mutual fund only provides its value at the end of the trading day.
Most ETFs track a particular index that measures some segment of the market. For example, there are multiple ETFs that track the S&P 500 index. The S&P 500 index is a measure of the stock performance of 500 leading companies in the United States.
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Therefore, if you were to purchase one share of an S&P 500 index fund, you would be invested in all 500 companies in that index, in their proportional weights.
This means that most ETFs are passive, which means to track an index. Again, their aim is to provide an investor exposure to some particular segment of the market in an attempt to return the average for that market. If there’s a type of investment that you want broad, diversified exposure to, there’s probably an ETF for it.
Though less popular, there are also actively-managed ETFs, where there’s a person or group that is making decisions about what securities to buy and sell within the fund. Generally, these will charge a higher fee than index ETFs, which are simply designed to track an index or segment of the market.
How Do ETFs Work?
To answer the question, “How do ETFs work?” it helps to start by thinking about how a mutual fund works, because mutual funds are slightly more intuitive.
Investors in mutual funds buy their shares from, and sell their shares to, the mutual funds themselves. Mutual funds price their shares each business day, usually after the trading day is closed.
To calculate the value of one share, the fund first calculates its total assets (minus its liabilities) to obtain the Net Asset Value (NAV) of its holdings. Then, the NAV is divided by the total number of shareholders.
Because ETFs trade on a continual basis, this pricing methodology wouldn’t be fast enough. ETF sponsors need to create and redeem shares throughout the day. Therefore, ETFs require market arbitrage to keep their prices accurate. How exactly does that work? Let’s take a look.
First, remember that an ETF trades like a stock. For this to happen, ETF sponsors generally have a relationships with one or more “authorized participants”—typically large broker-dealers. Generally, ETFs only work with authorized participants to purchase and redeem shares.
They are able to make fast exchanges with ETF sponsors when they need either large blocks of the underlying securities, called “creation blocks,” or when they are attempting to trade out the ETF fund shares themselves.
But this is only part of the story. ETF prices are constantly fluctuating with the buying and selling of that ETF. That’s the power of supply and demand at work.
Meanwhile, the same thing is happening with the underlying stocks held within the fund. Because of this, the price (also known as the market value) of the ETF can deviate from the price of its underlying assets (the Net Asset Value, or NAV).
This creates an opportunity for arbitrage, where a trader could potentially take advantage of the discrepancy between the NAV and the market value.
When these traders act in a way to take advantage of the discrepancy, it helps to close the gap, and push the two values closer. By publishing the NAV and allowing traders to act on the information, the market price of an ETF often stays near that of the NAV.
Benefits of Using ETFs
ETFs are gaining popularity as a tool for short and long-term investors alike—they make it easy to get started. Some investors may opt to take the DIY approach, and others will prefer to have someone help manage their ETF strategy. Either way, ETFs offer some benefits to the investors that choose to use them.
ETFs are often considered more tax efficient than a mutual fund. When shares of a mutual fund are redeemed, it is possible that capital gains taxes are passed through to investors.
Because ETFs generally “redeem” shares through an in-kind trade with an active participant, minimal capital gains taxes are triggered. ETFs typically pass through less capital gains costs than comparable mutual funds.
Talk to a tax professional to learn more about the potential tax benefits of an ETF.
ETFs and mutual funds charge what is called an “expense ratio,” which is an annual fee charged for upkeep in the fund. While both index mutual funds and ETFs are considered cost-effective ways to invest in the market, ETFs usually eke out some costs savings over index mutual funds.
Expense ratios aren’t the only fees charged by both ETFs and mutual funds, though. Because an ETF trades like a stock, there is often a transaction/trading fee to buy in and out of the fund.
Some mutual funds may have front-end load fees or back-end load fees that work in a similar manner, though you’d generally only see these fees on actively-managed mutual funds. Either way, make sure that you are looking at all of the fees involved in buying or selling any investment, not just the expense ratio.
Ever heard of the investing adage, “don’t put all your eggs in one basket?” That’s the idea behind diversifying your investments. Owning just one bond or one stock, or even a handful of bonds or stocks, can be considered risky.
By owning hundreds of investments all within one single investment, you minimize the risk of any one investment (such as a stock) doing poorly and tanking your portfolio along with it.
For example, if you were to buy an S&P 500 index ETF, you’re not just investing in one fund, but you’re investing in the 500 leading companies in the United States, achieving near-instant diversification. And by using an ETF, you get access to this diversification at a fairly low cost.
Investing in ETFs
There is no one way to use ETFs to invest. Some investors may be interested in the short-term moves of the market and use ETFs to place bets for or against those moves. Other investors may use ETFs to achieve broad, cheap exposure to the market in a long-term, buy-and-hold strategy.
For those interested in the latter, long-term strategy—which is likely most people—it is possible to buy a portfolio of ETFs through your brokerage firm of choice. This strategy will require you to choose investments that match up with your long-term goals and risk tolerance.
Investors who are interested in utilizing an ETF strategy but aren’t interested in the DIY approach may prefer to have the help of a professional.
Not only can the right professional help guide you into the right portfolio strategy for you, but they are there to help you manage your ETF strategy over the long-term. A professional can help you rebalance your portfolio and manage your investments from a tax standpoint.
If you want to invest in low-cost, diversified ETFs and have the support of investment professionals, check out SoFi Invest®.
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Tax Information: This article provides general background information only and is not intended to serve as legal or tax advice or as a substitute for legal counsel. You should consult your own attorney and/or tax advisor if you have a question requiring legal or tax advice.
Investment Risk: Diversification can help reduce some investment risk. It cannot guarantee profit, or fully protect in a down market.
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